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Taper Talk to Interest Rate Hike Hearsay

If your ear drums have not blown out from the overuse of the word 'taper' in financial media, then you will be happy to know the Fed announced it will be slowing its asset purchases by $10 billion next month. We mentioned this back in May in our piece "Closer to the Q-End?", highlighting the Fed's putting markets on notice and before interest rates spiked. Lately many folks guessed whether taper will come this month, in three months, or six months, we began to think about when and how an interest rate hiking cycle could come about.

The Fed governor speeches of late pledged to hold interest rates lower for an extended period, but recent meetings indicated the Fed is data dependent on jobs and inflation numbers for its decision making process. This really confused the bond market because if the Fed is allowing data to guide the Fed Funds policy, then without perfect foresight of future data, they cannot truly know interest rates will stay low for an extended period. Since forecasting of economic data is typically a fool's errand, then forecasting the Fed Funds rate might be nearly impossible. This is especially true since some of the signposts from history are not being followed.

Below are the average hourly earnings of private employees (blue). In the three previous interest rate hiking cycles, this data bottomed at the same time the Fed began raising interest rates (red). This time around though, the data rose steadily for the past year, yet no interest rate hikes occurred.

(Note these are not projections, simply the yield on fixed income and forward earnings yield on equities.)

These actions made the returns of less risky assets on the left side unattractive and thus reflated asset prices on the right side.

But despite the run-up in equity prices, mutual fund investors switched out of the anemic returns of cash and into bonds while shunning equities.

Source: Morgan Stanley Research

For households that became over-leveraged during the past real estate cycle, the low rates and rising asset prices helped improve the collective household balance sheet. Below is the household debt to GDP ratio, which this past quarter fell back to the same level as in 2003.

Because households focused on the repairing of balance sheets, demand for credit was low. The price of credit, i.e., interest rates, being so low, did not matter. Since lenders are weary of risky borrowers, credit standards also tightened. This led to money velocity being quite low, as credit has not really expanded even with the Fed holding rates down and repressing the investment opportunity curve. This is also a reason why inflation has not exploded despite the growth of the Fed's balance sheet.

With rhetoric discussing less open market purchases, the Fed is keenly watching these statistics. The other statistic Fed officials are watching is the unemployment level, as they stated back in December that should unemployment fall below 6.5% and inflation rises above 2.5%, a tightening cycle may begin, which would have repercussions for fixed income securities.

One factor driving the unemployment rate other than actual jobs is the labor force participation rate.(ii) Because baby boomers are a large part of the population, the demographic trend naturally skews older over time. Since retirees leave the labor force, they are not counted in the participation rate. A mathematician developed a very interesting model for forecasting unemployment based upon the labor force participation rate and it has efficacy across countries and over time.(iii) In fact, the model explains 82% of variation in the unemployment rate.

Source: Kitov

The current projections are for an unemployment rate of 6.0% at the end of 2013, from today's level of 7.5%. This is far lower than consensus forecasts and would accelerate the tightening of Fed policy should it turn out to be correct. While wildly optimistic, it is food for thought as the U.S. economy surprises the doubters.

This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.